How to Develop a Successful Trading Strategy with Those Three Tips

Develop a Successful Trading Strategy with Those Three Tips. Image source: kasto © 123RF.com

Developing a working trading strategy is a daunting task because there are many components that have to be considered simultaneously. Less experienced traders frequently find themselves confounded by the many aspects they have to factor in when developing their strategies. That is why we have composed this guide, to list the necessary steps traders need to make along the way to success on the market. 

Price action during the summer months is typically less volatile than usual because the aggregate trading activity falters. That is so because many market participants go on their summer holidays, leading to overall diminished liquidity. This seems like a good time for traders to fine-tune their strategies and make them more precise.

Directional vs Horizontal Price Action

In many regards, volatility exemplifies uncertainty in the market. The seemingly sporadic price fluctuations are actually bouncing between greater and less significant levels of support and resistance. That is why the first thing traders need to concern themselves with is determining the major thresholds on the chart of their preferred asset.

Distinguishing between SRLs (support and resistance levels) with minor and considerable importance is vital. It allows the trader to discern possible turning points for the underlying price action. But even more importantly, it is used for determining whether the market is trending or ranging.

The easiest way to spot the most important SRLs is to examine the asset in question on a daily chart. Look for multi-day peaks and bottoms on the price action (swing highs and swing lows). The behaviour of the price action around these prominent SRLs usually signals the next most likely direction for the market.

Depending on the behaviour of the price action around such prominent SRLs, the market could be either trending or ranging. That is the next necessary consideration traders need to reflect on in their trading strategy.

Using the Appropriate Trading Indicators in Ranging vs Trending Environments 

If a given asset is trending then the trader could decide whether to join an existing trend or to wait for a reversal. In other words, the trader can narrow down the available options to a decision between trend continuation strategies and contrarian trading strategies. Working top to bottom by narrowing one's alternatives makes for more consistent trading.

Conversely, in a ranging market, the trader needs to determine whether the horizontal price action is behaving logically or illogically due to random fluctuations. Afterwards, the trader can decide whether to buy/sell once the price action nears one of the existing range's boundaries or to sit and wait for a breakout play leading to the establishment of a new trend.

One of the easiest ways to determine whether the market is trending or ranging after all of the important SRLs have been established is by implementing the Average Directional Index (ADX) indicator on the daily chart. The ADX measures the strength of a trend. 

Once the index crosses above the 25-point benchmark, the market is said to be trending. Therefore, the further the ADX climbs above this 25-point mark, the stronger that the underlying trend gets. Accordingly, the more the ADX falls below this level, the more robust that the underlying range gets. You can find more information about this indicator in our trading book.

Choosing the right indicators for your trading strategy

Determining the condition of the price action is the first step. The trader then needs to select the right indicators that would best fit his trading strategy under these conditions. 

If the market is trending, the trader would have to monitor the underlying momentum of the price action. This is valid for both trend continuation strategies and contrarian trading strategies. The Moving Average Convergence/Divergence (MACD) is one of the most popular tools for measuring the price's momentum.

The MACD can highlight the distinctive price waves that comprise a broader trend. Usually, it does so in conjunction with other moving averages (for instance, the 30-day MA and the 50-day MA). Hence, traders seeking to join an existing trend can place buying/selling orders at swing lows/swing highs. We can determine this using the MACD, the SRLs, and other MAs.

Contrarian traders, in turn, can use the same instruments to look for oddities in the behaviour of the price action. For instance, waning momentum of the underlying price action close to a major SRL could potentially indicate exhaustion of the overall trend. Consequently, contrarian traders could then look for more pieces of evidence signalling a potential trend reversal and recalibrate their trading strategies accordingly.

If the market is ostensibly ranging, traders could use the Stochastic Relative Strength Indicator (RSI). It helps to determine when the market is 'Overbought' and when it's 'Oversold'. The price action tends to bounce between the boundaries of significant ranges –prominent SRLs usually underscore these. The price action is likely to jump up and down between the two boundaries of the range. 

The RSI illustrates the changing equilibrium between the buying and selling pressures on the market. If the indicator is in its 'Oversold' extreme while the underlying price action is nearing an existing range's lower boundary, then there would be a high probability for the emergence of a new upswing. Conversely, if the RSI is threading in its 'Overbought' extreme while the price action is nearing the range's upper boundary, then the market might be due for a new dropdown.

Applying proper risk management. 

Advanced risk management is arguably the most challenging aspect of perfecting any trading strategy. Although it's a powerful tool, the term has no simple explanation. Nevertheless, there are some basic guidelines traders can follow in order to cut their losses and allow their profits to grow.

First of all, do not forget to place stop-loss orders. The levels of support and resistance represent historic obstacles for the price action, and as such, they are frequently tested. Whether the price action manages to break them depends on the particular instance. Traders, however, need to remember to place their stop-loss orders relative to the position of the nearest SRL to the entry price level of the primary position.

Where to position the stop-loss?

Whether the stop-loss's placement is above or below the nearest SRL depends on the trader's own risk aversion. What we need to remember is that the market will fluctuate. Sometimes stop-losses will be triggered even if the market eventually goes in the trader's desired direction. This should not discourage the trader from using stop-loss orders in the future. Тhey represent the easiest and most effective way of achieving trading consistency.

Another essential thing to remember is exposure. As a general principle, it is not prudent to place trading orders when you expect the potential loss to exceed potential profits. In other words, trade only when you expect to gain more from the trade than what you are willing to risk.